Newbie Questions on Options

I've never traded an option contract. So I'm as green a newbie as you can get.

I am primarily a swing trader. My favorite plays are retracement pullbacks in uptrends. I buy the dip, sell the rally.

Why options? Two reasons, both stemming from being undercapitalized. First, the damn 25K SEC rule prevents me from making many swing trades in a week. Since options aren't governed by this rule, it is a place to turn. Second, many retracements are too "pricey" for me to play given my account size.

Let's say I want to play XYZ. XYZ is retracing, and is now selling for 40 dollars. I think XYZ will go to 46 or so as it re-enters the uptrend. But this stock is very volatile, and to capture the "swing low" on this retracement, I need a stop away from the market down to 37. Given my account size, capturing a stop at 37 on such a trade would mean that I would either have to buy a very small amount of shares to maintain my position sizing (so small that it would be worthless to trade it) or I'd have to increase my risk.

Neither alternative appeals to me.

Here's what I was thinking: I could buy a call option on XYZ with an out of the money strike at, say, 41 or 42. This would be a good strategy if the premium on the call was less than the cost of the stop (plus commissions) if I bought the shares outright, and less than or equal to my current risk per position in dollars.

This way I can play these sorts of retracements using options and not have to increase my risk.

Anyway, that's the idea. But I'm a newbie, so some questions:

1. What is liquidity like with these things? If I buy the call, and XYZ starts to go up, how fast can I resell this option? Is execution immediate, like a stock sell? Similarly if it goes down, if I put a stop on it, is there enough liquidity for me to get out?

2. What things do I need to think about here? Any suggestions on this? Is this a bad idea?

Wet,
I believe I am in the same situation as you are. I'm undercapitalized and will be doomed beginning September with the new SEC rule. I've started swing trading options a few months ago, and I've got some results, although I haven't been profitable yet. I have a few thoughts here:

1) I think it's a good idea to buy out-the-money (OTM)options because the premium is less. Moreover, if the position turns against you, you lose less than in-the-money(ITM) options. Of course, as you may already know, OTM options don't move in tandem with stocks, whereas ITM options move like stocks. However, depending on the technicals, timeframe and the premium, I also trade ITM options. For example, I usually buy ITM calls if I see a stock successfully testing its pivot point on pullback after it breaks out on high volume. On the other hand, when I anticipate breakouts, I usually buy OTM calls because pure breakouts plays are usually more risky than plays on pullbacks after breakouts, and I don't want to risk that much. (Of course, never buy too far OTM options simply because they are cheap, especially for swing trading. The stock might never come close to that option strike price. If you are doing longer positional trades, it might be a different story.)

2) Remember that options start to decay quickly beginning 10-8 days before expiration. Personally, I wouldn't pay hefty premium for an option when it's due to expire soon even though the underlying stock is a volatile one and is likely to move to my desired target in a few days.

3) Options are a lot less liquid than stocks--unless you trade household names like IBM, CSCO, etc., where there is more volume. So you have to expect the spread between the bid and the ask to be pretty wide--sometimes could be as much as 35 to 40 cents per contract. So options are bad trading vehicles if you only set out to capture 1 point's move or less. It's just not worth the risk counting the slippage and commissions. However, it's a great trading vehicle if you set out to capture larger moves, meaning more than 1.5 points.

4) I've fiddled with bull-spread vertical strategies, meaning that I buy a lower call and then sell the higher call to reduce the overall premium I need to pay. The rationale for selling a higher strike is that you want to wait for that option to expire to collect the money. However, I don't find that to be a good swing strategy, since my trades tend to last for a few days. As a swing trader, you don't have that much time to wait for an option to expire, and although selling the call would further reduce your downside risk, it also limits your upside potential. You feel like your hands are tied. Vertical strategies, I think, work best when you are doing positional trades on a steadily trending stock. In that case, you can buy a deep ITM option many months away from expiration and then sell those options nearing expiration.

4) One other point I want to make is regarding the use of stop orders as part of your risk management. My experience is that unless you trade options with a lot of liquidity, it's counterproductive to use stop orders, because your stop orders can trigger very easily precisely due to the lack of liquidity. Right now, I use exclusively mental stops based on the technicals. If the technicals have changed contrary to my plan, then I exit the option position. In any case, don't relax your risk management rules simply because options risks appear to be more limited.

Hope this helps. Good luck for your trading. Keep us posted about your results.

Keep things simple at the beginning. Don't experiment with too many option strategies like butterflies, etc. just yet, since like myself you don't have that much capital to lose. Trading options is already one step more complicated than trading stocks, in that you've got to do all the homework you'd have to do when trading stocks. Plus, you've got to find out which stocks are optionable and then do all the rest of the homework you need to do as an option trader.

Optionist has some very good points. I would add that you should read as much as possible about options. I would suggest "Options as a Strategic Investment" by Larry McMillan. One of my first option trades was CSCO. I felt like the stock was going to move up significantly so I bought an OTM Call. The underlying was at 57 and the front month 65 Call was selling for 2.5. The stock moved to 67 and I sold the call for 3.5!!!

A 10 point move in the stock and I got 1 point - minus commissions no less. That's when I learned about volatility. Be sure to check out volatility, both implied and historical as you get further into option trading.

There's no magic bullet or holy grail with option (or any other) trading. The first thing you need is a solid strategy and risk mgmt and being able to trade stocks is important. Right after that, you need to get capitalized. This is a good place to hang out to find out how to do both. I'd also look into interactivebrokers.com for the cheapest option commissions - 1.95 per contract - no minimum.

wet,
if you are looking for liquidity you're probably best off trading at the money or one strike out of the money options. For speed, if the options trade on Auto-Ex (electronic fills on the various floor exchanges) or on the ISE you should get an instant fill.

I actually do exactly what your taking about using candlestick patterns and S/R levels. I started out basically for the same reasons you are thinking about this. I had limited capital but I wanted to trade as many equities/markets I could.

Its a good idea, in a way, but there are things you need to think about when trading options that you don't need to consider with stocks.

I'll try to give you a run down of what I found to be the most important factors to consider. My time frame is probably much longer than what your interested in but most of these will still probably apply to you.

1. Theta : The amount at which the options contracts price decays per day.
I would say this should be considered if you plan to buy a contract that is near expiration (Within 3 weeks). I trade with an average of several days to 2 months. So I will buy contracts that are 4-5 months down the line, incase I have to hold it for longer than a month, to avoid as much time decay as possible. Remember an options time decay is much more rapid in the last few weeks of its life.

2. Delta : The amount by which an option's price will change for a corresponding one point change in price of the underlying entity.
Here is the thing about delta's, the more in the money an options contract is the closer the delta gets to a 1:1 ratio. So my advice would be to in the money contracts or 1 strike out. The downside to buying in/near the money contracts is that the contract will be more expensive (especially if the expiration is some times away) and you will take larger swings because the delta will be at a higher ratio.

3. I don't think about the volume in the options contract that much, and this is because the options price will move regardless if anyone is trading that contract. So I've found you can make money on a contract even if your the only one trading it. Although if you happen to need a big order executed you may want to look for options with volume.

4. Remember the more volatile the underlying stock the higher the options price will more likely have.

5. Read Stockoptionist rule (3). Since you will most like need to buy on the ask (Not always). Once you are executed you are technically at a loss already. Keep this in mind.

6. Calculating a stop price. Now this may get a little tricky. One the options price is always decaying. What is the delta in your current contract. You will probably need to sell @ the bid (Not always). And that could be quite a large spread.

When trading options your potential for profit gets greater but so does the potential for loss.

There maybe something I forgot but this is what I think about the most. As far as execution goes, you probably wont have that much of a problem if your lots are small.
I will advise however that trading options on an intraday basis, in manner like daytrading stocks, I don't recommend. Unless the underlying stock has a very, very good daily range.